You are developing the Marginal Cost of Capital schedule for

You are developing the Marginal Cost of Capital schedule for your firm. You expect the firm to bring in earnings of $900,000 and have a dividend payout ratio of 30%. The firm can issue $750,000 in debt at 7.5% after-tax before the cost jumps to 8% after-tax. The firm’s preferred stock costs 8.5%. Retained earnings cost 9% while new issues of common stock cost 10%. The target capital structure is 10% preferred stock, 60% common equity, and 30% debt. Determine the weighted average costs of capital (WACC) to use on the marginal cost of capital schedule.

Solution

1) Retained earnings available for investment = 900000*(1-0.30) = 630000 Total investment possible with retained earnings alone as equity =630000/0.60 = 1050000 WACC = 9*60%+8.5*10%+7.5*30% = 8.50% 2) With debt upto 750000: Total investment possible = 750000/0.30 = 2500000 WACC for investments from 1050001 to 2500000 = 10*60%+8.5*10%+7.5*30%= 9.10% 3) For investments beyond 2500001, WACC = 10*60%+8.5*10%+8*30% = 9.25%